What is the PE Ratio?
• The PE Ratio or price-to-earnings ratio is a financial variable that evaluates the price per share relative to the annual net income of the underlying company. As a result, the PE Ratio can alternatively be calculated by dividing the underlying firm’s market capitalization by its total annual earnings.
• The PE Ratio is a financial ratio used by analysts and investors for valuation purposes: a higher PE ratio means that an investor is paying more for each unit of net income. In these situations, the stock is more expensive compared to one with a lower PE Ratio.
How do I Calculate a Stock’s PE Ratio?
• The PE ratio is defined as the following formula:
o PE Ratio= Price per Share/Annual Earnings per Share
• The price per share component of the PE ratio is the market price for a single share the underlying company’s common stock. The earnings per share, which is the denominator in the PE ratio, will depend on the type of price-to-earnings ratio utilized.
o There are three different types of price-to-earnings ratios: Trailing, continued operations, or forward price to earnings. A trailing price to earnings ratio refers to the company’s net income for the recent year (12-month period) divided by the number of shares issued. The trailing PE ratio, instead of net income, uses the company’s operating earnings, which will exclude earnings from discontinued operations, accounting changes or extraordinary items. And lastly, the Forward PE ratio uses the company’s estimated net earnings over the next 12 months.
Examples of PE Ratios:
• If a stock’s price is $25 and the EPS for the most recent 12 months is $5, the underlying stock has a P/E ratio of 25 divided by 5, or 5. As a result, an investor who buys shares of this stock is paying $5 for every dollar of earnings. Those companies with negative earnings (losses) will have an undefined PE ratio that will usually read as N/A.
• The ability to compare price and earnings per share for a company enables a prospective investor to analyze the market’s valuation on the stock and its shares relative to its income. Stocks with better forecasts (higher earnings growth) will have a higher PE ratio and vice versa.
• Although the PE ratio is an effective tool in analyzing stocks, all companies are different and comparisons between industries and time periods may be inconclusive or misleading.